On December 18, 2018 the Competition and Markets Authority (CMA) published an update paper following the launch of its market study into the statutory audit market in October 2018.
In the update paper, the CMA summarises its concerns that the audit market is not currently delivering consistently high quality and it also sets out its views on what is driving these quality concerns. Section 4 of the paper then sets out a proposed package of remedies to address the issues it has found. These are as follows:
Regulatory scrutiny of audit committees – remedy 1
The CMA proposes that audit committees should be subject to specific regulatory requirements and obligations. It currently believes that this regulation should include:
A requirement that audit committees report directly to the regulator before, during and after a tender selection process. The regulator would also have the ability to include an observer on all or a sample of audit committees.
A requirement that audit committees report directly to the regulator throughout the audit engagement.
The ability for the regulator to issue public reprimands or direct statements to shareholders.
The CMA proposes that this remedy should apply at least to all FTSE 350 audit committees but it welcomes views on whether the remedy should be extended to cover a wider group of companies, such as all public interest entities.
Mandatory joint audit – remedy 2
The CMA’s provisional view is that joint audits would increase competition without risking audit quality. In terms of design, its initial views are:
The main aim of the remedy is to reduce the barriers facing challenger firms. The CMA’s preferred way of achieving this would be by mandating that at least one of the audit pair is a challenger firm.
The remedy should at least apply to FTSE 350 companies, possibly with some limited exceptions where the nature of the company would not sensibly justify a joint audit. Views are sought on whether the remedy should apply to other large companies or whether specific types of company should be excluded.
Each joint auditor should have to be granted a significant proportion of the audit work. The minimum proportion to be assigned to any joint auditor might vary across FTSE 350 companies and over time to allow challenger firms to build their capacity.
A possible alternative to a mandatory joint audit would involve imposing a market share cap on the Big Four firms so that a given proportion of the market is reserved for challenger firms. Again, this remedy would initially apply at least to FTSE 350 companies but the CMA seeks views on whether it should apply to other large companies that could be in the public interest. However, the CMA prefers mandatory joint audits to a market share cap as a means of breaking down barriers to non-Big Four firms competing successfully for larger audits.
Additional measures to support challenger firms to be considered further – remedy 3
The CMA favours the prohibition or limits on the length of non-compete clauses as they make it harder for audit partners and staff to switch firms. Partner switching is seen as necessary for challenger firms to build their capacity. The CMA is to investigate this matter further and asks for evidence to support the claim that there are csignificant and unreasonable barriers to senior staff switching between the claim that there are significant and unreasonable barriers to senior staff switching between firms. The CMA also proposes to look at a number of other measures such as technology sharing as access to technology could, in principle, make challenger firms better able to compete for FTSE 350 audits and so increase auditor choice for companies.
Market resilience – remedy 4
This remedy would create a market oversight and resilience regime in the event of a likely or actual failure of a large audit firm in the UK. It would ensure that there remains adequate choice of auditors in the market, while maintaining competition and quality both on its own and as part of a package of remedies.
The CMA notes that the remedy warrants further consideration and it asks for views on how an effective resilience regime could be designed to avoid going from the Big Four to the Big Three. It states that the remedy should apply at least to the Big Four. However, it may also be appropriate for some large challenger firms to come within scope if they grow in relative size.
Full structural or operational split between audit and non-audit services – remedy 5
The CMA does not believe that the current framework for managing non-audit services conflicts is sufficient to focus auditor’s incentives on high quality audits. It considers that one way to address the reality and perception of non-audit service related conflicts would be to structurally separate audit and non-audit services. However, it recognises that there are important practical challenges in creating audit-only firms and so it is considering other variants of this remedy that could be effective, but less costly. For example, one possible solution might be for firms to implement an operational split between the audit and non-audit parts of the firm, with separate profit pools and governance arrangements for audit and non-audit.
Either form of separation, whether it is full structural or an operational split, should apply to at least the Big Four but the CMA seeks views as to whether this remedy should also apply to challenger firms.
Peer review – remedy 6
The CMA proposes that an important element of the regulator’s toolkit should be a peer reviewer who can identify under-performance as it happens and whose presence may actually stop any under-performance occurring. The peer reviewer should be independent, appointed and paid by the regulator, and owe a duty of care only to the regulator.
The CMA proposes that the regulator should have the ability to determine the scope of the peer review function, perhaps initially targeting this at companies that it considers high risk or which require additional scrutiny.
The CMA notes that at this stage, it is minded not to make a market investigation reference because it sees recommendations to the Government as a more effective route to implementation. Submissions on any of the issues addressed in the update paper are requested by January 21, 2019. The CMA will continue to gather evidence, meet with stakeholders and undertake analysis with a view to refining its proposed remedies and issuing a final report as soon as possible in 2019.
(CMA Statutory Audit Services Market Study – update paper, 18.12.18)